Regulators Fear A Bubble In Mortgage REITs, Eye Stricter Oversight

By Michael Aneiro

The Wall Street Journal‘s Deborah Solomon reports today that financial regulators are eyeing mortgage real-estate investment trusts as a possible risk to the U.S. financial system, calling it “the latest example of Washington’s growing concern with market bubbles.” From the Journal:

Next week, the Financial Stability Oversight Council, a panel comprising the top U.S. financial regulators, is expected to cite mortgage REITs as a source of market vulnerability in its annual report, according to people familiar with the matter, a distinction that could set the stage for stricter oversight of the industry.

Eager to avoid the mistakes of the past, regulators are attempting to identify overly frothy activity before it poses problems. Even though the economy continues to recover only slowly, regulators see potential bubbles forming in a range of financial markets, in part because of the Federal Reserve’s easy-money policies, which have driven interest rates to near-record lows and prompted investors to seek higher returns elsewhere.

Mortgage REITs, which are publicly traded financial companies that borrow funds to invest in real-estate debt, have seen their assets quadruple to more than $400 billion since 2009. They differ from traditional REITs in that they invest in mortgage debt, rather than actual real-estate like office buildings or shopping malls. The firms take advantage of inexpensive, short-term borrowing to buy mortgage securities backed by Fannie Mae (FNMA) and Freddie Mac (FMCC) and offer returns to investors of as much as 15%.

They join leveraged loans and money-market mutual funds as areas of risk cited by officials. Three Federal Reserve officials have singled out mortgage REITs in recent weeks, saying the industry merits watching.

Taking advantage of low borrowing rates, mortgage REITs buy longer-term mortgage-backed debt and use leverage to boost returns. The story ties the heightened scrutiny to the rapid growth of companies like Annaly Capital Management Inc. (NLY) and American Capital Agency Corp. (AGNC), whose assets have ballooned to more than $100 billion apiece over the past three years, while the industry’s market capitalization has grown from $22.1 billion to $59 billion during that time. Defender of mortgage REITs say they have grown by virtue of an expanding capital base. As for what could happen to mREITs:

The FSOC’s labeling of mortgage REITs as a source of risk doesn’t mandate changes but could set the stage for stricter oversight of the firms, which aren’t subject to the capital standards or leverage limits that large banks face. The Securities and Exchange Commission, whose chairman is an FSOC member, could opt to regulate mortgage REITs under the Investment Company Act, or the FSOC could designate an individual firm as a “systemically important financial institution,” subjecting it to heightened capital standards and Fed oversight.

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There are 8 comments

APRIL 19, 2013 8:35 A.M.

Suradit wrote:

Much ado about nothing more than some federal agency trying to give the impression that it's doing something to justify its cost to the tax payer. Nothing of substance will be done until after the potential risk becomes reality and once again the government has to bail out systemically important businesses.

APRIL 19, 2013 8:57 A.M.

George Costanza wrote:

What's riskier than the Fed's action of buying up $85 billion worth of Tresuries and MBS every month with money created out of thin air? MREITs at least are using private capital to back the mortgage market.

APRIL 19, 2013 9:10 A.M.

Douglas Rife wrote:

mREITS weathered the financial crisis very well compared to Freddie and Fannie and many banks. Their structure assures they must raise more equity capital by issuing new shares in order to by more MBS. NLY and other mREITs have made new offerings of shares several times since 2008. Banks, in contrast, got into trouble by having too little equity capital. It's also the case that mREITs have played an important roll in the housing recovery as they have taken up the slack after many structured finance products based on MBS were turned into toxic assets and shunned by investors. Increased oversight should not be seen as a bad thing by investors.

APRIL 19, 2013 9:39 A.M.

Darnoc wrote:

I think that regulators would be more worried about those counterparties that have taken the risk from the mortgage REIT's upon their balance sheets through various derivatives.

APRIL 19, 2013 12:18 P.M.

Richard wrote:

I wish banks would be regulated a bit more rather than these REITS. A mere deflection tactic.

APRIL 19, 2013 4:48 P.M.

Roger in KY wrote:

While generally correct that these assets are not (usually) toxic, especially if dealing in insured housing MBS.

OTOH, these MREITs tend to be highly leveraged. NLY has reduced its leverage to "only" around 6 from around 8. More aggressive entities like AGNC have higher leverage, and pay stunning dividends, like 15%, That;s fine, until the financial tide turns against them. Then they get risky and their dividends can plummet as liquidiations are needed.

I think some regulation to keep an eye on these, since they have often EXPLODED in size due to a yield chasing investment public, is not a bad thing.

Better safe than have lots of different entities like this suddenly place massive unexpected strain on the financial system the next time things go really awry.

APRIL 19, 2013 7:48 P.M.

sj wrote:

As long as mortgage is cheaper than renting, there is no bubble. Feds is doing it right. There are less foreclosures now.

APRIL 20, 2013 9:05 A.M.

jim quicjk wrote:

and the point is??? just instill fear in shareholders? pointless article

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.